Introduction

An essential requirement for economic growth and sustainable development is the provision of efficient, reliable and affordable infrastructure services, such as water and sanitation, power, transport and telecommunications. Traditionally, infrastructure was the exclusive province of the public sector, with large, state-owned enterprises (SOEs) being responsible for investment and service delivery. Typically, the SOE sector was a costly and inefficient provider of infrastructure in most developing countries.¹ However, encouraged by international organisations such as the World Bank, privatisation has been a major component of the economic reform programmes pursued by many developing countries over the past two decades (Parker and Kirkpatrick, 2004a). Privatisation was predicted to promote more efficient operations, increase investment and service coverage, and to reduce the financial burden on government budgets (World Bank,1995). Much of the early privatisation activity was concentrated in the manufacturing sector, but recent years have seen donor agencies advocating the privatisation of utility industries in developing countries and the introduction of semi-autonomous, dedicated regulatory bodies for these industries within government (World Bank, 1995,1997). A large number of developing countries have introduced some private participation into their infrastructure industries, especially telecommunications, and to a lesser degree in electricity and water.

Utilities such as water supply, gas, electricity andtelecommunications and certain modes of transport such as rail, include natural monopoly characteristics arising from pervasive economies of scale and scope. These characteristics mean that competition is unlikely to develop, or if it develops it will be uneconomic because of the duplication of assets. Although technological advances, notably in telecommunications, have whittled away some of the natural monopoly characteristics in utilities, permitting economic competition in certain areas of service delivery, nevertheless each of the utilities retains some natural monopoly features. As a consequence, privatisation of these industries, in whole or in part, risks the introduction of private-sector monopolies that will exploit their economic power in the market place, leading to supernormal profits (high 'producer surplus') and reduced consumer welfare (a lower 'consumer surplus'). Consumers suffer from no or a limited choice of goods and services and face monopoly prices.

To prevent this result, governments need to develop strong regulatory capabilities so that they can police the revenues and costs of production of the privatised utility firms and protect consumers from monopoly exploitation. It is argued that privatisation leads to greater incentives for managers to pursue productive efficiency because of the superior principalagent relationship in the private sector compared to government (Vickers and Yarrow, 1988; Bös, 1994). But at the same time, in the absence of the threat of competition, managers could dissipate potential cost savings through padding their staffing, raising their own salaries and by pursuing an 'easy life' (Martin and Parker, 1997, ch.1). The results of privatisation where private-sector monopolies are created are therefore uncertain and this is born out by empirical studies that have demonstrated that the greatest cost savings from privatisation occur in competitive industries (e.g. Vickers and Yarrow, 1988; Martin and Parker, 1997; Kikeri and Nellis, 2001). Moreover, monopoly firms price above their marginal costs of production leading to allocative inefficiency. It is, therefore, the task of the regulatory office to ensure that productive and allocative efficiency gains occur and that consumers benefit from lower prices and improved services.

As DFID (2000a, pp23-25) comments: 'Effective governments are needed to build the legal, institutional and regulatory framework without which market reforms can go badly wrong, at great cost – particularly for the poor.' This suggestion is supported by a growing body of empirical evidence that confirms that the quality of the regulatory environment has a significant effect on an economy’s growth performance (Jalilian et al, 2003; Alexander and Estache,1999). More particularly, in the case of utilities, the evidence confirms that 2 privatisation brings greater benefits when it is accompanied by an effective regulatory regime (Wallsten, 2001; Zhang et al., 2003a,b; Pargal, 2003). A large number of developing countries have introduced new, dedicated regulatory offices to supervise the activities of their privatised utilities, sometimes even when the utilities remain wholly or largely state owned. Most of these regulatory offices are expected to have some degree of independence from day-to-day political control, although in practice political intervention seems to occur in a number of countries (Cook et al. (eds) 2004). Utility industries provide essential public services, and have an important role to play in meeting the needs of the poor (Willoughby, 2003). Often, the poor in developing countries suffer from both a high degree of exclusion from access to infrastructure services, and from poor quality of those services they purchase (Clarke and Wallsten, 2002). This suggests that regulation in developing countries may face a greater dichotomy than in developed countries between promoting economic and social goals (Smith, 2000). What is deemed regulatory ineffectiveness in one context, for instance, a failure to remove cross-subsidies that favour the poor, may not be in another context where poverty reduction is a primary goal of public policy. In practice, the industry regulator will need to pay detailed attention to tariffs so as to balance the need to supply poor households with affordable infrastructure services, with ensuring that companies earn sufficient profits to satisfy their investors. This may involve the use of subsidies to suppress tariffs, as for example, in the output-based aid (OBA) approach where the payment of a subsidy to the operator is made conditional on the private operator having delivered the specified output or performance measure (Brook and Smith, 2003).

Despite the importance of regulation in affecting the performance of privatised utilities, comparatively little consideration has been given to the detailed design of institutional structures and regulatory instruments appropriate to the conditions and capacities that characterise different developing countries. In most cases the new regulatory offices that have been created have been modelled on those in Western Europe, the USA or Australia. At the same time, there exists no comprehensive audit of the methods used by regulatory bodies in developing countries, although it does seem that, here again, advanced country practice has been followed, as for example in the widespread adoption of the price cap form of regulation, at least in Latin America (Guasch, 2001).

The objective of this paper is to review the experience of infrastructure regulation in low and middle income countries, to assess the applicability of this experience to developing Asia, and to identify areas for future research on infrastructure regulation in the low and middle income economies of the Asia region.

The paper is structured as follows. The next section reviews the recent growth in private participation in infrastructure in developing countries and describes the sectoral and geographical distribution of private investment in infrastructure. The third section is concerned with the theory of economic regulation, which is used to provide a framework for analysing regulation in developing countries. Section 4 deals with models for regulating prices and profits in utilities. Section 5 reviews the evidence on the use of different models for price and profit regulation in developing countries. The focus in section 6 is on the electricity and water sectors. A review of the evidence on the process and results of privatisation in each sector serves to highlight the differences in the characteristics of the electricity and water sectors, which are then related to a discussion of regulation design for each sector. Section 7 discusses issues of regulatory capacity and regulatory governance in developing countries. The final section proposes a methodological framework for conducting research on infrastructure regulation and identifies a number of issues for future research on infrastructure regulation in developing Asia.

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